The Bad Economics Behind Stimulus Spending

Economist John Taylor (Stanford University) says government intervention caused the market meltdown of 2008 and that “short-run government spending” has only made matters worse. He dismisses the theory that stimulus spending can jump-start an economy as an “old-fashioned” Keynesian illusion.

Economist John Cochrane (University of Chicago) says the Keynesian theory of stimulus spending to end recessions is so wrong that it is now taught “only for its fallacies.”

Economist Greg Mankiw (Harvard University) says the Keynesian economic model “pretty much ensures” the conclusions that Keynesian practitioners guarantee – among them, the astonishing multiplier effect that transforms every borrowed dollar into an increase in GDP of $1.57.

Economist Robert Barro (Harvard University) says Keynesian assumptions have been thoroughly disproven. “Just because an economy is in crisis,” he says, “it doesn’t invalidate everything we have learned about macroeconomics since 1936.”

These eminent economists (and many others) affirm celebrated Nobel Prize economist Milton Friedman’s conclusion about New Deal stimulus spending in the Great Depression: “It hampered economic recovery, prolonged unemployment and set the stage for ever more intrusive and costly government.”

In developing his own $60-billion economic stimulus package, Finance Minister Jim Flaherty placed his bet on Keynesian theory as fashionably renovated for U.S. President Barack Obama by a new crew of super-optimistic macroeconomists. The doctrine is politically powerful. Who wouldn’t go another dollar into debt if the transaction guaranteed a return of $1.57? And, at first glance, Mr. Flaherty appears to have won his wager. Canada’s economic numbers are positive. GDP is up. Unemployment is down. The markets are down but not ominously so. John Maynard Keynes still looks good.

Across the border, though, Mr. Obama appears to have lost the bet. The markets are downright skeptical. Unemployment remains high. In May, the U.S. economy generated 400,000 government jobs, but only 40,000 private sector jobs. Many Americans now think their President has assumed massive debt for precious little gain; for these folk, as one economist expressed it, “stimulus has become a dirty word.”

Why the cross-border difference? It could be that Canada, one way and another, did a better job than the U.S. in managing its stimulus spending. Or it could be luck. Or, it could be that Canada didn’t actually need any stimulus spending at all – as Mr. Flaherty himself originally suspected.

This is the more probable explanation. The United States, after all, out-borrowed and out-spent Canada by a factor of four. This wasn’t stimulus. It was a temporary government takeover. But Stanford University’s Prof. Taylor, for one, wasn’t surprised that it didn’t work. Indeed, he anticipated it. In a Wall Street Journal essay last year, Prof. Taylor explained why: Short-term income gains do not increase consumption – the essential assertion of Keynesian doctrine. He cited, as an example, the big one-time tax rebates (household average: $500 U.S.) that the U.S. government mailed to taxpayers in 2008. Rather than increase consumption, the rebates precipitated a national retreat from consumption.

One problem with stimulus programs, Prof. Taylor argues, is that they are deliberatively designed as “temporary, targeted and timely.” To increase consumption, they would need to be “permanent, pervasive and predictable.” The only stimulus programs that meet these three criteria are permanent tax cuts – a definition, for what it’s worth, for 20 per cent (or $3.2-billion Canadian) of Mr. Flaherty’s $19-billion stimulus program for this year. In contrast, the U.S. increased taxes.

Prof. Taylor is an internationally recognized economist. He served as a senior Treasury Department official in three White House administrations (Ford, Bush 1 and Bush 2). He devised the “Taylor rule,” a formula used by central banks to determine short-term interest rates. (For every percentage point increase in inflation, the Taylor rule specifies a 1.5-point increase in interest rates; for every percentage-point decline in GDP, it specifies a half-point drop in interest rates.)

Last year, Prof. Taylor published a provocative 59-page minibook: Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis. What went wrong? Prof. Taylor says the Federal Reserve kept interest rates far too low for far too long, giving people access to an enormous supply of cheap money. He blames Fed chairmen Alan Greenspan and Ben Bernanke for imposing an interest rate policy “with little or no basis in economic theory.”

Prof. Taylor argues that there never was a significant “liquidity problem” in the U.S. financial system; there was only this cheap money hiding the subsequent rise in risk as lending practices got progressively looser. This error, he says, cost the global economy $12-trillion (U.S.) in lost financial assets.

Here at home, Liberal Leader Michael Ignatieff and NDP Leader Jack Layton are calling on the Conservative government not to reduce the corporate tax rate next year – and to use this saving (perhaps $8-billion) to finance more stimulus spending. This would waste as much money as eight G8-G20 summits. Mr. Flaherty should stand firm, as he undoubtedly will.